Wednesday, December 30, 2009

Some finance companies have recently announced that they will offer bond instrument investments without government guarantees in the near future. Some have added that these instruments will offer a return 1% higher than their equivalent with a guarantee.

David Chaston of the rates blog wonders if this is “enough”… as he points out money that was going to the government would simply go to the investor (assuming the investment survives).

One clue as to what the pricing should be comes from the credit rating of the companies making the offer…. which is at present BB+ I use two data sources to price the spread for a given instrument issued by a company with a given rating – www.bondsonline.com – which provides a spread table showing spreads between US Treasuries and corporate bonds of equivalent maturity with a given rating and a slightly modified database derived from Damodaran who draws from Bloomberg. I increase the spread slightly to allow for the virtually total absence of liquidity in N.Z. relative to mature markets.

From these sources we see that the premium ought to be between 2.58% and 4.25% with no government guarantee. If the government guarantee (which is capped and bound by some conditions – so is not a 100% safeguard) is worth 1% then the question is whether or not spreads between say 1.50% and 3.25% are sufficient to offset the risk of finance company instrument investing.

An interesting point is that the spreads do not change in a “straight line”. Once companies reach investment grade (BBB) there is a significant reduction in the spread (as much as 2%) – at least as measured by these data sources. Put differently, falling below investment grade appears to carry a greater than linear rise in risk – and we should expect returns offered to acknowledge that.

Sydney Morning Herald writer Ross Gittens summarises Greg Mankiw’s ten principles in this short, easy to read piece. The trick is understanding the full implications and applying these consistently.

Here's a never-to-be-repeated holiday special: all you need to know about economics in 10 easy steps. They come courtesy of the best-selling introductory economics textbook by Gregory Mankiw of Harvard University (with Joshua Gans and Stephen King co-authors of the Australian edition).

Economics is the study of how society manages its scarce resources, where ''scarce'' means there are fewer resources than we'd like to be able to use.

The first four of Mankiw's 10 principles concern the way people make decisions, and the first is: people face trade-offs. That is, to get one thing we like we usually have to give up another thing we like.

Economics is about the trade-offs people - and societies - have to make, and about helping people improve the trade-offs they're making.

One common trade-off society faces is between efficiency and equity. Efficiency in the allocation of resources means society getting the most it can from its scarce resources. Equity means the benefits from those resources are distributed fairly among the members of society. Often, the things we could do to make the cake bigger (efficiency) make the slices of the cake more unequal (equity) and vice versa.

The second principle is: the cost of something is what you give up to get it. That is, its ''opportunity cost''. Economics is about comparing the costs and benefits of alternative courses of action. The benefits of doing something or buying something are usually pretty obvious, but they need to be weighed against the costs involved to see whether option A is superior to other options.

The cost of going to university full time is not the cost of accommodation and food (because you'd face those even if you didn't go to uni), nor even just the cost of the uni fees and textbooks. The biggest cost is the income you lose by not being able to work full-time - a classic opportunity cost.

Third, rational people think at the margin. Marginal changes are incremental adjustments to a plan of action. Say you're running a short course for 10 students at a total cost of $10,000 - that is, an average cost of $1000 per student.

Now say an extra student wants to join the course. How much should you charge him - $1000? No. The first question is: what's the marginal cost of adding an extra student? It's probably quite small - say, $50 for the extra set of course notes.

This means that any price you charge above the marginal cost of $50 will leave you ahead on the deal. But if you name a price that's too high and the student decides not to pay it, you're worse off to the extent that the amount he would have been willing to pay (marginal revenue) exceeded $50.

Fourth, people respond to incentives. Because people are assumed to make decisions by comparing costs and benefits, their choices may change when the costs and benefits change. If so, they're responding to incentives.

When Cyclone Larry caused the price of bananas to skyrocket in 2006, most people ate fewer bananas and more apples and pears. They were responding to changed incentives.

The next three principles concern the way people interact. The fifth is: trade can make everyone better off. Trade between Australia and China is not like a sporting contest where one side wins and the other loses.

Rather, trade makes both sides better off (though not necessarily equally better off), which is why it happens. Trade between countries is merely an extension of all the trade that goes on within countries between businesses and households.

Sixth, markets are usually a good way to organise economic activity. A market economy is ''an economy that allocated resources through the decentralised decisions of many firms and households as they interact in markets for goods and services''.

The other main way to organise economic activity is to have central planners make all the decisions about what goods and services are produced, how many are produced, who does the producing and who gets to buy what's produced. It doesn't work.

Seventh, governments can sometimes improve market outcomes. Government intervention in markets may be justified in cases of ''market failure'' - ''a situation in which a market, left on its own, fails to allocate resources efficiently''.

One common cause of market failure is the existence of an ''externality'', where a transaction between a buyer and a seller affects - whether favourably or unfavourably - the well-being of third parties.

Another cause is ''market power,'' where one or a small group of firms is able to substantially influence market prices (and thus make profits well in excess of the opportunity cost of the capital they have put up and the risks they are taking).

The last three principles concern how the economy as a whole works. The eighth is: a country's standard of living depends on its ability to produce goods and services. The value of a country's production of goods and services during a period is measured by gross domestic product.

A simple measure of its material standard of living is its GDP divided by the size of its population. Income per person is very much higher in the developed countries than the developing countries. Why? Mainly because the rich countries have higher productivity - each hour of a worker's time produces more goods and services.

Why? Because the rich countries' workers are better educated and trained (''human capital'') and have better equipment to work with (''physical capital'').

Ninth, prices rise when the government prints too much money. This proposition is usually true, but it doesn't apply when - as now in the United States and Britain - the demand for goods and services is falling far short of the available supply of goods and services.

Tenth, society faces a short-run trade-off between inflation and unemployment. Usually, the things governments do to reduce inflation have the effect of increasing unemployment and the things they do to reduce unemployment have the effect of increasing inflation.

This relationship is known as the ''Phillips curve'' after the Kiwi who invented it, but in the long run the trade-off breaks down and if you push it too hard you can end up with high inflation and high unemployment. If you can get people's inflation expectations down, however, you can enjoy the best of both worlds.

If you've followed me this far you've passed the course. Your reward: look up the economics professor and stand-up comedian Yoram Bauman on YouTube and watch his send-up of these 10 principles.

Sunday, December 27, 2009

The Obama administration pledged Thursday to provide unlimited financial assistance to mortgage giants Fannie Mae and Freddie Mac, an eleventh-hour move that allows the government to exceed the current $400 billion cap on emergency aid without seeking permission from a bailout-weary Congress.

...But even as the administration was making this open-ended financial commitment, Fannie Mae and Freddie Mac disclosed that they had received approval from their federal regulator to pay $42 million in Wall Street-style compensation packages to 12 top executives for 2009.

The compensation packages, including up to $6 million each to Fannie Mae and Freddie Mac's chief executives, come amid an ongoing public debate about lavish payments to executives at banks and other financial firms that have received taxpayer aid. But while many firms on Wall Street have repaid the assistance, there is no prospect that Fannie Mae and Freddie Mac will do so.

Tuesday, December 22, 2009

“It is not by the intermeddling of Mr. Southey’s idol, the omniscient and omnipotent State, but by the prudence and energy of the people, that England has hitherto been carried forward in civilization; and it is to the same prudence and the same energy that we now look with comfort and good hope. Our rulers will best promote the improvement of the nation by strictly confining themselves to their own legitimate duties, by leaving capital to find its most lucrative course, commodities their fair price, industry and intelligence their natural reward, idleness and folly their natural punishment, by maintaining peace, by defending property, by diminishing the price of law, and by observing strict economy in every department of the state. Let the Government do this: the People will assuredly do the rest.”

Thursday, December 17, 2009

We have long suspected (since it makes sense) that management will often forego projects which make sense for the company but are too risky for them personally on a portfolio basis because they are already exposed to the firm via their jobs and maybe even options.

Reuter’s Felix Salmon explains why and how….

What’s the correlation between wealth and risk appetite? I suspect that it’s somewhat bell-shaped: when you’re very poor you can’t afford to take any risks, while if you’re entering the middle classes you often feel that you have to take risks, especially with your retirement assets, if you’re going to have a chance of maintaining your standard of living once you stop working.

If you already have more money than you’ll ever spend, however, then you don’t need to take those kind of risks any more, and you start becoming much more conservative again — see for instance the way in which Suze Orman is invested only in wrapped munis.

This big picture can be blurred by the fact that many of the riskiest investments, like venture-capital funds or leveraged hedge funds, are invested in only by the wealthy. But look a bit closer and you’ll invariably find that the investors in those funds are careful to make sure they’re set for life before taking a small percentage of their wealth and investing it in high-risk assets.

But thanks to a new law, we can now see how senior executives invest their money. And it turns out that even diversified stock-market investments are too risky for them:

Top executives at Bank of New York Mellon Corp. could invest their savings in a fixed-income fund that had a 6.6% return in 2008; thanks to electing this fund, Steven Elliott, senior vice chairman, had earnings of $1.3 million on his account, according to filings.

Executives at Cummins Inc. could choose among three options: the return on the S&P 500, “the Lehman Bond Index, or 10 year Treasury Bill + 2%,” according to filings. The executives at the engine maker had a total of $1.4 million in gains on their accounts, suggesting that none of them elected the stock index.

Executives at Illinois Tool Works Inc., a maker of fasteners and adhesives, received returns of 6.1% to 8.4% in 2008, while investments in the employees’ 401(k) lost 25%. A spokeswoman says that so far this year, the average return of employees’ 401(k) plans has been 23%, while the interest credited to the executives’ deferred-compensation plan is just 5.6%.

The WSJ implies, and Ryan Chittum makes explicit, the concept that any executives seeing gains in their retirement accounts were somehow getting special treatment, compared to ordinary employees whose 401(k)s got destroyed.

But the bigger point here is that the rich executives are simply availing themselves of the luxury of being able to afford very low risk, modest-return investments. (As ever, Comcast is the outlying villain, guaranteeing senior executives a 12% return on their savings. Yuck.)

I’d also be interested in finding out how much company-specific credit risk is involved in these schemes. A giveaway is the word “notional”:

These deferred-compensation plans generally provide notional investment elections that mirror the returns on mutual funds available in the employee 401(k) plan.

In other words, we’re not talking about actual returns on actual money, here, we’re talking about notional returns on notional money which is really just an unsecured liability of the company to the executive.

If the company goes bust, the money disappears — and even if it doesn’t, the money might not ever arrive. Just ask Fred Goodwin and Dick Grasso whether promised retirement funds are certain to become real cash.

There’s something to like about the fact that senior executives have an enormous amount of their retirement assets tied up in unsecured obligations of their employer: it gives them a strong incentive to avoid the kind of fat-tailed risks which could really wipe them out. So I’m not as shocked by the WSJ story as Chittum is. Except for that Comcast factoid, of course.

Sunday, December 13, 2009

We might think of sub-Saharan subsistence economies when we think of Fairtrade, but the biggest recipient of Fairtrade subsidy is actually Mexico. Mexico is the biggest producer of Fairtrade coffee with about 23% market share. Indeed, as of 2002, 181 of the 300 Fairtrade coffee producers were located in South America and the Caribbean. As Marc Sidwell points out, while Mexico has 51 Fairtrade producers, Burundi has none, Ethiopia four and Rwanda just 10 – meaning that "Fairtrade pays to support relatively wealthy Mexican coffee farmers at the expense of poorer nations".

Coffee farms must not be more than 12 acres in size and they are not allowed to employ any full-time workers. This means that during harvest season migrant workers must be employed on short-term contracts. These rural poor are therefore expressly excluded from the stability of long-term employment by Fairtrade rules.

Tuesday, December 8, 2009

It must be admitted that my knowledge of marketing is somewhat limited, I struggle to see it as a “deep” discipline – certainly in the sense of say physics or philosophy - but I have sufficient grip of the general outline to know that:

total exposure to one idea can be fatal,

differentiation is a good idea,

premium brands can generate premium margins, and,

a bit of thought before jumping to conclusions generally pays.

I am then a little surprised that in the “cows in a cube farm” debate no one seems to be seeing that the very fact of having some dairy exports produced on pasture – the so called premium product many, including the well known behemoth, believe we are famous for, and some produced by more intensive means offers a great opportunity – if we are smart enough.

There is the opportunity to broaden the offering, differentiate the premium product, diversify a bit of product risk, produce a lower cost segmented product while reducing environmental impacts – all while increasing output massively.

God’s rather than the devil’s work one would have thought.

Economists have spent several lifetimes trying (mostly without any degree of success – scalping aside) to figure out how to price discriminate so as to pick up more customers by appealing to as many tastes as possible through different price offerings for very similar goods.

Here it is on a plate – or rather in a cube. A clean cube that uses water more efficiently, allows easier less costly clean up, promotes animal welfare and lowers relative if not absolute cost. But oh no….

Ironically for the green fraternity cleaning up the environment raises their animal welfare hackles (demonstrably misguided in this instance). Fear of insufficient bovine hugging may threaten cleaner dairying.

Monopolists and near monopolists don’t need to care too much about price discrimination – which is why they are poor at scalping – brute force, especially statutory brute force is enough. Yet here is the chance to ramp up the premium pasture product while selling to hungry mouths wanting lower cost product.

Greater overall volumes and a segmented offering with a lower cost product underpinning a premium product suite has to offer some opportunities.

Using current policy development methods, the quickest road to implementation of this new form of production would of course, be a referendum with 90% voting against it.

Tuesday, December 1, 2009

Here is an entirely speculative exploration of the inevitably if irritatingly termed GFC and in particular the role of derivatives. It draws little on empirical data for there are few of relevance, and depends instead upon logic built atop the kind of framework the late Fischer Black might have used as a point of departure.

That framework starts with the premise that the GFC was an equilibrium event – that is to say that whatever it was, it was not the idiosyncratic result of irrational behaviour driven by levels of greed and fear hitherto unobserved and peculiar to a certain class of rogue, thief or corrupt capitalist (who can be vanquished by regulatory fervour and adoption of some moral high ground).

It was, and we should let future events continue to be, business as usual.

I assert that the GFC and of greatest interest here, the entire of the global derivative instrument portfolio deployed at the time the “crisis” struck, were standard rational responses – and here is the challenging hypothesis – which represented, in aggregate, more optimal responses by capital markets to then prevailing conditions than the responses implicit in the critics cries of despair, or indeed any other responses.

Second, Black’s (and others) standard requirement to accept that the world is not perfect. Rather, it is the best we have and thus we must accept and make the best of it. So both nirvana and greener fields fallacies are forbidden in the analysis.

Assume there were no derivative instruments. So no slicing and dicing of risk into credit default swaps. no collateralised debt obligations and no short selling instruments – or the kind of regulatory interventions now advocated, such that these markets were effectively closed down or were too expensive to operate at all.

What might have happened? We don’t know. We can speculate. A few obvious starters. With Clinton and his ilk advocating lending regardless of credit risk in the interests of “equity” or similar policy notions, demand would have been just as high as what was observed. High demand for sub prime loans. Motown on full tilt borrowing.

Competition to meet demand, retain market share, even grow would surely have been as rife as that observed. Lenders then, keen to lend. With wider economic growth strong pressure would have been strong.

Likely response? Carry on up the jungle. With the FDIC underwriting lending why on earth wouldn’t banks have kept lending into the feeding frenzy? Just like 1980s S&Ls.

True, we would not expect all banks to fall for this. They didn’t. They survived – maybe prospered. Amongst 8,300 (see below) you would expect that. But…

Before the fall, when they wrote it on the wall, the FDIC had $60bn (2007) to underwrite the moral hazard of the 8,300 FDIC guaranteed U.S. banks. A clear invitation to party…. and they would have. Just as they did in the S&L crisis of 1980s when derivatives weren’t even a blink in the Milken eye.

So imagine 8,300 banks all lending like crazy with only the FDIC as insurer – that is the counterfactual. No risk transfer, easy credit, political encouragement and, to cap it, the idiotic Mae and Mac fiefdoms of shareholders fleecing taxpayers while management had the biggest time.

Writing decades ago, Magellan guru Peter Lynch couldn’t understand why everyone wasn’t all over Fannie. No brainer transfer of direct to equity investors right out of the US treasury.

How good was that FDIC insurance? By August of 2009 with 64 banks in default the FDIC funds were down to $13bn from the $60bn reserve of a year previously. So, headed pretty much to DC for a top up.

That’s 0.8% only of the banks in default. In short, a tiny number in default. And so tiny because of the derivative market that transferred so much much risk away from the oh so rapidly heading for zero FDIC.

What did CDOs and like instruments do? They had already transferred the risk - away from governments and taxpayers – to people who were better placed to wear those risks.

Were these folks happy to lose? Of course not but they were better placed to wear it than taxpayers.

Exposure, worldwide, to CDOs was estimated variously by Reuters and Bloomberg to be around $US33 trillion in August of 2009. Reliable data? In precise terms likely not – the point here though is the sheer size of the risk spread and transferred relative to not spreading that risk.

The FDIC is lost in the rounding here. Not seriously in contention.

Even if the U.S. share was a small proportion of that and it had not been transferred then there would have been a serious bloodbath – more than enough to make Keynes's eyes water. Instead, worldwide creditors and investors shared, on a global scale – and some still have yet to share – the pain.

The message from economics is often “it could be worse, think of how well off you are compared with the alternative”. I’m suggesting that nothing has changed. The derivatives let people if not shuck off then at least share $33 trillion of pain.

When even one reform which seeks to kill derivatives can offer even a 10th of that benefit it might be worth waking up for.

The data can be out by magnitudes here but the Fischer Black idea – let’s imagine this is equilibrium, remains profound – and the guys from the government are simply not “the smartest guys in the room.”